The Hindu Business Line : Forex risk management

An active treasury management policy can protect an enterprise from financial shocks and assist in predicting future cash flows and earnings more accurately.

Treasury is no longer about cash management alone.

Kuntal Sur

The challenges posed by the global business slowdown, credit crunch, and liquidity scramble have raised the bar for treasury. Last year, many Indian corporates suffered losses especially due to the high volatility of the rupee against the US dollar.

The losses due to movements of foreign exchange have dented the overall performance of companies and their future outlook. This has brought the focus back on treasury and its foreign exchange risk management function.

Role of treasury

Treasury is no longer about cash management. This entails a hands-on role in handling financial risks against the background of assessing general economic conditions. In this direction, the implementation of a ‘treasury risk policy’ can be an invaluable aid to manage financial risks at a predefined tolerance level and in an effective and efficient manner.

Every company’s policy is a unique proposition and should be consistent with its business and risk philosophy and well understood by the affected employees.

The policy should spell out the roles and responsibilities of business units and functions and define an easily understood risk management and hedging framework.

An active treasury management policy can protect an enterprise from financial shocks and assist in predicting future cash flows and earnings more accurately. A strong treasury risk management framework also improves a company’s creditworthiness and enhances its ability to borrow.

Also, the management of financial risks is instrumental in protecting firms from unexpected cash drains which, in a worst case scenario, can lead to insolvency.

Key aspects

Some of the other key aspects to keep in mind while defining a risk management policy are:

Time horizon for risk management: The optimum time horizon for risk management varies from sector to sector as well as between organisations. The fundamental principle in defining a time horizon for risk management is simply that a company should manage its exposures sufficiently far into the future to allow itself to adapt to adverse changes in currency and/or interest rates.

Defining exposures and setting limits: It is important to define limits (net exposures after considering inflows and outflows in respective time buckets) by different risk types and by currency.

The objective of defining a limit is to ensure market movements do not adversely affect the firm in a way that might seriously threaten its viability or undermine the confidence of its customers, debt and equity holders. The risk limits should follow from a defined risk appetite (based on credit rating, cash flow volatility, margins, capital structure, etc.), which should be approved by the board.

For multi-currency operative units, it is advisable to define exposures to major currencies and convert them to a base (functional) currency (the main earnings currency or the financial reporting currency).

The forecasts are done based on a base case scenario, which represent “best estimate” cash in and outflows.

As per leading practices, increasingly the base case scenarios are evaluated under various “downside” conditions. These “stress test and scenario analysis” results, as they are typically referred to, reflect exchange rate and cash flows under different scenarios.

Most companies in India use spreadsheets to measure foreign exchange exposures and before and after hedging. This may hinder the growth of the treasury business and, in many cases, it has led to an increase in operational risk. As the number of transactions and the currencies of exposures increase, it is advisable to move towards more sophisticated treasury management system solutions for a more accurate estimation of cash flows.

Choice of instruments: Optimal instruments are identified based on management’s risk tolerance. Each instrument is evaluated for cost, risk profile, complexity, accounting implications and compliance with regulatory norms. Country-specific legal requirements and the availability of these instruments in these markets are also taken into consideration.

For non-convertible currencies, “proxy hedging” strategies are assessed (example, hedging EGY via USD). The corporate can decide how much to hedge based on the weight of forex risk on total earnings or cash flow at risk.

Apart from financial instruments, alternative strategies such as natural hedging (cash inflows in foreign currency (sales) should be used for cash outflows in the same currency (purchases)) and currency netting (netting of group-wide forex cash flows), among others, may be implemented.

Monitoring of exposures: The forex risk of a firm is dynamic and ever changing. The forex risk exposures (position data) need to be monitored on periodic basis and reported to the investment committee/board. When there are cross-currency exposures, the hedge effectiveness needs to be measured and monitored.

Many of the losses incurred by Indian corporates last year have been due to a unidirectional view of forex movements. In these cases, scenario analysis was not considered and hedging instruments (primarily relying on forward market, and not on other instruments such as currency options) were not properly evaluated.

As the option contracts involve paying option premiums upfront, many corporates avoided these instruments. However, after a period of rupee appreciation (against the dollar), the rupee started depreciating against the dollar from January 2008 and most of the corporates who got into forward contracts were caught napping. As the rupee depreciated further and touched Rs 50 to a dollar many of them cancelled their forward contracts. The costs of cancellation of forward contracts are higher than the ‘option premiums’ they would have paid otherwise. This is a result of taking a short unidirectional view of rupee movement, without considering the downside of the ‘forward’ contracts.

Earnings volatility

By providing the treasury a decision-making role — through developing an appropriate forex risk management framework, periodic monitoring of the positions and above all choosing the right resources — treasury mangers can considerably reduce the volatility of earnings.

The optimal way of choosing hedging strategy involves evaluating alternative market scenarios and then adapting the hedging plan which suits the corporates’ risk appetite. The performance of the chosen strategy should be compared with the alternative regimes and the effectiveness of hedging results should be documented.

The learnings from the past should be taken into considerations while formulating future strategies. Following these basic principles will assist corporates to steer the ship in times of turbulence.

(The author is Associate Director, Financial Risk Management, KPMG Advisory Services.)

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